Investing in sin stocks is not for everyone, but they often provide unparalleled cash flow and remarkably high dividend yields to keep otherwise on-edge investors happy. While there are many sin sectors we could focus on, including alcohol, casinos, and firearm producers, I'd instead prefer to focus on the sector with arguably the biggest bull's-eye on it from both a legal and ideological perspective: the tobacco industry.
U.S. lawmakers are making it increasingly difficult for tobacco companies to sell their products. Numerous states have raised their tobacco tax rate over the past decade, while the FDA recently released a ruling requiring tobacco companies to affix large warning labels to their packages and advertisements by October 2012. In sum, the going has been tough for tobacco companies in the U.S., and it's likely to get tougher.
Thus it makes sense to look past the dividend paid by most tobacco companies and dig deeper to see whether you have a payout you can trust for the long term, or a high-yield smoke-and-mirrors candidate. While the tobacco sector doesn't offer a vast selection of choices, there are two clear-cut dividend standouts and one company that could burn you if you aren't careful.
Philip Morris International
What's the best way to avoid U.S. regulators? How about by avoiding the U.S. altogether!
Philip Morris International, the Altria
Relative to Altria, or even rival Lorillard
Reynolds American is the second-largest domestic tobacco producer behind Altria and faces many of the same legal woes that Altria faces in the U.S. So why should you even consider investing domestically considering the argument for Philip Morris above? Reynolds American's healthy balance sheet and its burgeoning smokeless tobacco business are two reasons that come to mind.
Relative to Altria, Lorillard, and multinational rival British American Tobacco
The main driver behind Reynolds' future dividend growth will be its smokeless tobacco revenue, which currently accounts for 8% of its business. With companies like Star Scientific
Reynolds American's dividend growth rate over the past decade is a blistering 11.3% and based on its current yield of 5.6%, it looks poised to motor higher over the coming years.
Whereas many of the above names have momentum in their favor, Vector Group -- the company behind the Liggett, Grand Prix, Eve, Pyramid, and USA brand names -- is heading in the opposite direction.
Like Altria, Lorillard, and Reynolds American, Vector Group operates solely within the United States. But Vector is much, much smaller. With a market cap of only $1.3 billion and just over $340 million in cash on its balance sheet, Vector is considerably more vulnerable to lawsuits than its counterparts. In recent years, Vector has seen its earnings per share fall, while shareholders have witnessed a sharp rise in debt, from $156 million in 2006 to more than $530 million by the end of 2010.
Possibly the most disturbing factor about Vector Group is that the company has recently had to issue debt to finance its 9% dividend payout. The company earned just $0.81 per share on a trailing-12-month basis, but has paid out $1.56 in dividends during that time. Vector's payout ratio currently sits at an unsustainable 193%. Between the company's declining shareholder equity, its soaring payout ratio, and its widening debt load, I definitely can't recommend anything other than avoiding this company.
Tobacco dividends come with inherent regulatory risk, but if you're prudent in your research, you can potentially uncover some smoking hot deals. Just be careful not to become enamored solely with current yields in this sector, as it could be a quick path to getting burned.
Are you willing to invest in tobacco stocks given the legislative oversight they face worldwide? Share your thoughts in the comments section below and consider adding Philip Morris International, Reynolds American and Vector Group to your watchlist to keep up on the latest news in the tobacco sector.